January 7, 2020

The Big Market Delusion: Uber Is Not Alone

Soon after its introduction as a private company, the market value of Uber began to explode.  One reason was the potential size of the market.  Uber was billed not only as a potential global ride sharing company, but as a new kind of transportation company. If Uber could capture a meaningful fraction of this gigantic market, it could easily be worth tens of billions of dollars.  By the time of its IPO, Uber as well was pitching the “big market” story.  In the prospectus Uber described itself as a personal mobility business and defined the personal mobility business to include all things transportation related.  This led to an assessment of the total accessible market (TAM) of more than $ 6 trillion.

Uber is not alone.  Among the new markets forecast to be huge by companies entering the spaces are artificial intelligence, meatless meat, office leasing, rental housing, ride sharing, fintech, and video streaming to name a few.  Venture capitalists also tout the value of big markets.  Don Valentine, the storied founder of Sequoia, one of the world’s leading venture capital firms, always stressed the importance of big markets saying, “Our objective is always to build big companies — if you don’t attack a big market, you’re highly unlikely to build a big company.”

To provide a few current examples, Roku’s stock is up approximately 400% this year and appeal to a big market is at the core of much of the enthusiasm.  For instance, one bullish Roku analyst wrote, “In 2020, Roku’s key upside valuation driver will be accelerating SVOD [subscription video on demand] revenues, which lowers investment risk, we believe.”  It is basically the same story with alternative meats.  Although Beyond Meat’s stock price has backed off from its astronomical highs, it is still richly valued based on the huge future market.  One analyst put it this way, Beyond Meat will reach $1.8 billion in revenue by 2025, up from an estimated $275 million in 2019. Key to a projected 36% compound annual growth rate is a dramatic ramp up in food service revenue.  These forecasts assume that BYND achieves around 10% penetration of total US grocery (plant-based meat) category sales by 2025 and captures around 15% penetration of the total US food service market.”  This story is repeated over and over.  Because the potential market a company hopes to serve is so big its growth potential is tremendous justifying an eye-watering value.

But do big markets really translate into wonderful opportunities for investors in young companies entering those markets?  In a recent research paper, Aswath Damodaran and I investigated this question in some detail.  (The full paper is available to download at www.cornell-capital.com).  The title of the paper, The Big Market Delusion, foreshadows our conclusion.  In our view, the big market delusion is a one-way ticket to overvaluation.  In the paper, we argue that entrepreneurs and venture capitalists, overconfident in their own abilities, are naturally drawn to big markets which offer companies the possibility of huge valuations if they can effectively exploit them.  In practice, the big market delusion results in too many new companies being founded to take advantage of big markets, each company being overpriced by its cluster of founders and venture capitalists.  This results in eventual corrections as the evidence accumulates that growth must be shared, not only with existing firms but also with a host of new entrants, and profitability is difficult to achieve in a competitive environment.  For instance, the airline market is a big one but throughout most of its history airlines companies have struggled to attain profitability.  Warren Buffet went so far as to say, “if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

As one specific example of how the big market delusion operates, we examined the history of the social media market in its start-up phase of 2015.  We started by noting that at the revenue of social media companies was almost entirely due to the sale of advertising.  Furthermore, the companies claimed they had no intention to charge their members in the future.  The business model would remain based on advertising.  That being the case, the total value of all the social media companies should be limited by the size of the global advertising market.  This leads to the question of whether the advertising market is big enough to justify the growth assumptions impounded in the stock prices of social media companies.  Answering that question took a good deal of analysis which we describe in the paper.  The conclusion we reached was that even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 comes to $466 billion. The imputed 2025 revenues from the publicly traded companies that existed in 2015 exceeds that number.  This implies that the companies were being overpriced relative to the market (online advertising) from which their revenues were derived. As more companies line up to enter this space, the gap between the aggregate market value of companies in the space and the size of the advertising market from which they are expected to derive revenues must continue to grow.

To illustrate the volatility that the big market delusion can cause consider the cannabis market which is also analyzed in the paper.  The widespread view as of October 2018 was that the cannabis market would be a big one, in terms of users and revenues.  On this basis, the stock prices of Cannabis companies exploded.  For instance, Tilray saw its stock price increase ten-fold to a market cap of $13 billion despite revenues of only $28 million and earnings before interest and taxes of negative $20 million.  By October 2019, the assumptions regarding growth and profitability were being universally scaled back, business models were being questioned, and investors were reassessing the pricing of these companies.  As a result, Tilray saw its stock price drop by 80%.

On Saturday, December 14, the Wall Street Journal published an article entitled The Moneymen Who Enabled Adam Neumann.  It referred to several slides in a pitch book prepared by investment bankers.  One slide said, “Your path to $1 trillion” referring to a target market of $1 trillion.  Another slide said only, “Growth is paramount.”  The big market delusion was in full force.


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